Japan's Stock Market Goes on a Tear

On December 29, 1989, amid a gigantic bubble in virtually all Japanese assets, Tokyo's Nikkei 225 index closed at a high of 38,916. By March 10, 2009, at the bottom of the global bear market in stocks, the index closed at 7,055 — a plunge of 82% from its peak.

During that 20-year stretch and beyond, the Bank of Japan has made repeated efforts to stimulate the economy, as has the Diet, Japan's national legislature. But their efforts have been far too little to cure what ails Japan: The country has been mired in debt and has been suffering from deflation.

Every five years or so, the Japanese stock market rallies and some analysts get bullish. So far, they've all been wrong. Most recently, a three-year rally in Japanese stocks was choked off in 2008 when the Bank of Japan failed to turn on its printing presses amid the global financial meltdown — and saw a soaring yen cripple its economy. Then, in 2011, an earthquake and tsunami and the resulting nuclear disaster temporarily derailed the economy.

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Could this time be different? It could be, says Taizo Ishida, the Japanese-born lead manager of Matthews Japan Investor (symbol MJFOX). The new government has promised bold policies that should lead to a weaker yen, which Ishida considers crucial for Japan's revival.

New Prime Minister Shinzo Abe is the main reason for being bullish. He promises precisely the weaker yen that Ishida views as so important. Much will depend on whom Abe appoints as head of the Bank of Japan, but Abe pledges to name a central banker who will adopt dramatic quantitative easing policies in the mold of Federal Reserve Chairman Ben Bernanke in the U.S. In addition, Abe is calling on the Diet to enact additional programs to stimulate the economy.

So far, the markets believe. Abe was elected on December 26 in a landslide victory for his Liberal Democratic Party. From that day through February 18, the Nikkei index has gained 11.5%. The yen, meanwhile, has plunged. From requiring only 76 yen to buy $1, it now takes 94 yen to buy a buck. A weaker yen makes Japanese exports more competitive in the global economy.

Japan faces huge problems that will almost certainly prevent it from regaining the position it held in the late 1980s. Government debt as a percentage of gross domestic product is 220%, compared with about 100% in the U.S. China's economy has grown exponentially over the past few decades, passing Japan's as the world's second-biggest economy. Japan is resource-poor. The nuclear catastrophe and subsequent decision to turn away from nuclear power only exacerbates that problem.

Longer term, Japan faces a demographic crisis that dwarfs those in Europe and the U.S. About 22% of Japan's population is over age 65 — a number expected to grow to 40% by 2050. "There's no way to get around the demographic challenge," says Campbell Gunn, who manages T. Rowe Price Japan (PRJPX). Unlike the U.S., the country has long discouraged immigration and has one of the lowest rates of women in the workplace in the developed world.

Based on its price-earnings ratio, Japan's stock market looks pricey. The Nikkei index trades at 25 times earnings for the previous 12 months. Ishida says, however, that's because earnings are deeply depressed.

A better way to determine value in the Japanese market is to compare price with book value (assets minus liabilities). The Nikkei trades at just 1.4 times book value. By contrast, Standard & Poor's 500-stock index trades at about two times book.

In spite of all of its problems, Japan is one of the world's most technologically advanced countries and boasts some of the largest and strongest companies — particularly in autos and electronics.

Both the Matthews and T. Rowe Price funds are solid choices, though the Matthews fund has had slightly better returns since Ishida took over as lead manager five years ago. Over the past five years through Feb. 18, the Matthews fund has returned an annualized 0.7%, and the T. Rowe Price fund lost an annualized. 2.0%.Clearly, you'll need to put aside these weak returns if you intend to invest in Japan or in either of these funds.

If you buy the bullish case, and it is intriguing, don't go overboard. I wouldn't put more than 5% of my stock money in Japan. And before you invest, check your broad-based international funds to see how much you already have in Japan. As for me, I'm going to let my diversified foreign funds nibble where they see value. I'm not ready to buy a Japan-only fund.